6-1 McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. IMPORTANT: In order to view the correct calculator key stroke symbols within this PPT, you will need to follow the font installation directions on this document.this document

6-2 Key Concepts and Skills Know the important bond features and bond types Understand: –Bond values and why they fluctuate –Bond ratings and what they mean –The impact of inflation on interest rates –The term structure of interest rates and the determinants of bond yields

6-3 Chapter Outline 6.1Bonds and Bond Valuation 6.2More on Bond Features 6.3Bond Ratings 6.4Some Different Types of Bonds 6.5Bond Markets 6.6Inflation and Interest Rates 6.7Determinants of Bond Yields

6-4 Bond Definitions Bond –Debt contract –Interest-only loan Par value (face value) ~ $1,000 Coupon rate Coupon payment Maturity date Yield to maturity

6-5 Key Features of a Bond Par value: –Face amount –Re-paid at maturity –Assume $1,000 for corporate bonds Coupon interest rate: –Stated interest rate –Usually = YTM at issue –Multiply by par value to get coupon payment

6-6 Key Features of a Bond Maturity: –Years until bond must be repaid Yield to maturity (YTM): –The market required rate of return for bonds of similar risk and maturity –The discount rate used to value a bond –Return if bond held to maturity –Usually = coupon rate at issue –Quoted as an APR

6-7 Bond Value Bond Value = PV(coupons) + PV(par) Bond Value = PV(annuity) + PV(lump sum) Remember: –As interest rates increase present values decrease ( r  → PV  ) –As interest rates increase, bond prices decrease and vice versa

6-8 Debt versus Equity Debt –Not an ownership interest –No voting rights –Interest is tax-deductible –Creditors have legal recourse if interest or principal payments are missed –Excess debt can lead to financial distress and bankruptcy Equity –Ownership interest –Common stockholders vote to elect the board of directors and on other issues –Dividends are not tax deductible –Dividends are not a liability of the firm until declared. Stockholders have no legal recourse if dividends are not declared –An all-equity firm cannot go bankrupt

6-9 The Bond Indenture “Deed of Trust” Contract between issuing company and bondholders includes: –Basic terms of the bonds –Total amount of bonds issued –Secured versus Unsecured –Sinking fund provisions –Call provisions Deferred call Call premium –Details of protective covenants Return to Quiz

6-10 Bond Classifications Registered vs. Bearer Bonds Security –Collateral – secured by financial securities –Mortgage – secured by real property, normally land or buildings –Debentures – unsecured –Notes – unsecured debt with original maturity less than 10 years Seniority –Senior versus Junior, Subordinated

6-11 Bond Characteristics and Required Returns Coupon rate –  (risk characteristics of the bond when issued) –Usually ≈ yield at issue Which bonds will have the higher coupon, all else equal? –Secured debt versus a debenture –Subordinated debenture versus senior debt –A bond with a sinking fund versus one without –A callable bond versus a non-callable bond

6-12 Bond Ratings – Investment Quality High Grade –Moody’s Aaa and S&P AAA – capacity to pay is extremely strong –Moody’s Aa and S&P AA – capacity to pay is very strong Medium Grade –Moody’s A and S&P A – capacity to pay is strong, but more susceptible to changes in circumstances –Moody’s Baa and S&P BBB – capacity to pay is adequate, adverse conditions will have more impact on the firm’s ability to pay Return to Quiz

6-13 Bond Ratings - Speculative Low Grade –Moody’s Ba, B, Caa and Ca –S&P BB, B, CCC, CC –Considered speculative with respect to capacity to pay. The “B” ratings are the lowest degree of speculation. Very Low Grade –Moody’s C and S&P C – income bonds with no interest being paid –Moody’s D and S&P D – in default with principal and interest in arrears

6-14 Government Bonds Municipal Securities –Debt of state and local governments –Varying degrees of default risk, rated similar to corporate debt –Interest received is tax-exempt at the federal level –Interest usually exempt from state tax in issuing state

6-15 Government Bonds Treasury Securities = Federal government debt –Treasury Bills (T-bills) Pure discount bonds Original maturity of one year or less –Treasury notes Coupon debt Original maturity between one and ten years –Treasury bonds Coupon debt Original maturity greater than ten years